Rent or buy: A case for home ownership

By JEFF ROSS Correspondent

Jul 27, 2014 | 3:00 AM

Over the last several years, I've been asking myself why people are renting, when many can afford to purchase.

Sure, there are many individuals whose credit was impacted by the recession. Some couldn't afford to keep up with credit card payments. Others were forced to sell their homes as a short sale, and yes, there were those who lost their homes to foreclosure.

There are still those whose credit scores are at an acceptable level to a mortgage lender, and they have the financial wherewithal to purchase today. Yet they are either on the fence about buying or they don't realize that they have the capacity to buy. In other words, they don't know what they don't know. In fact, depending upon the sales price of the home, on an annual basis, it may be less expensive to own than rent.

Let's look at an example. Assume you are renting a townhome for $1,600 per month. After one year, you will have paid your landlord a total of $19,200. Your landlord gladly takes your money with a big smile on his face. For simplicity sake, let's assume there are no annual rent increases. At the end of five years, you have paid a total of $96,000 in rent. So, you've paid out almost $100,000 in rent and have nothing to show for it.

If instead, you purchase a townhome for $250,000. Let's say your down payment is $12,500. You ask the seller to pay 3 percent of the sales price in closing expenses. Your monthly principal and interest payment on a 4.5 percent 30-year fixed rate loan is $1,203.

Add real estate taxes, hazard insurance, which covers the lender's investment in the structure, mortgage insurance, protecting the lender in the event of a default by the buyer and the homeowner's association fee, which pays for items like community amenities, common area maintenance and snow removal. The total payment would be roughly $1,775 per month.

At first glance, you must be thinking, this guy can't add. If my rent is $1,600 per month and my proposed mortgage payment is $1,775, how can he say that I'm going to pay less to own than to rent?

There is a method to my madness. What you must recognize is that the federal and state governments still allow us to deduct mortgage interest and real estate taxes from your income taxes. Let's carry the analysis through to its conclusion.

Over the first five years of homeownership, you will have paid, give or take a few dollars, a total of $51,200 in mortgage interest, or $10,240 per year. Assume for federal tax purposes, you are in the 28 percent tax bracket. Add to that a Maryland state tax rate of 7.5 percent. Your total tax rate between federal and state is 35.5 percent.

If you take 35.5 percent of $10,240, you will recognize an actual, "in your pocket" tax savings of $3,840. Add to that, $12,500 for five years of real estate taxes or $2,500 annually. At the same 35.5 percent tax rate applied to mortgage interest, you can deduct approximately $888 per year in real estate taxes. Between mortgage interest and real estate taxes, your real tax savings equal almost $400 per month.

You may be thinking that the additional $175 per month above your $1,600 in rent makes you a bit uncomfortable. That being said, you will need to consult with a CPA or tax advisor to determine if you can possibly increase the number of withholding allowances you are currently claiming on the W-4 form you completed for your employer. The premise is that if you can increase the number of allowances, you will see more money in each paycheck, which will help you absorb the payment difference between your current rent and your payment to own.

Now you're thinking, maybe this guy does know what he's talking about. Taking into consideration the total monthly payment of $1,775 to own, and subtracting from that the roughly $400 per month in actual tax savings, you have just reduced your total monthly payment to own to $1,375. In actuality, you would be paying almost $250 per month less to own than to rent.

Great news for you, I'm not done yet. Your initial investment to purchase was $12,500. Over the first five years, you have retired nearly $21,000 of the original principal balance on your mortgage loan. Assuming a conservative appreciation rate of 3 percent per year, at the end of the fifth year, your property will have appreciated by $39,800. Your total equity in the property at this point in time is $73,000. We're talking about a swing of nearly $173,000 between renting and owning. That's a huge number by anyone's standards, isn't it?

I realize it's cliché, but we're in the "perfect storm." Property values are increasing modestly year-on-year in Anne Arundel County, and we are now in year six of historically low interest rates. We've all heard the adage "what goes up, must come down." The inverse is also true.

In other words, interest rates can't stay at these low rates indefinitely. Short term interest rates have been hovering near zero since December 2008. In fact, Federal Reserve chairman Janet Yellen has already indicated that there will be an increase in interest short term rates in mid-2015. The idea is to raise them gradually, but the economy appears to be picking up a head of steam and inflation fears may require tweaking the plan.

If values continue to rise and interest rates rise, the affordability index is impacted. What this means to you as a prospective homebuyer is that you can expect to be able to afford less home if your income remains constant.

What do you think? Is it a gamble you are willing to take, or should you consider playing it safe and purchasing sooner rather than later?